5.3.4—Monetary policy in AD/AS

A change in monetary policy can shift aggregate demand by changing consumption, investment, net exports and sometimes asset prices. The direction is clearer than the size of the effect.

Lower interest rates usually reduce the cost of borrowing and the reward for saving, may raise asset values, and can weaken the exchange rate. Higher rates generally work in reverse. Banks, confidence, debt and the trade response determine the transmission.

A rate cut may increase mortgage disposable income and investment, shifting AD right. If the economy is near capacity, the main result may be a higher price level rather than much extra real output.

The AD shift is not the same size in every economy, and monetary expansion cannot instantly shift productive capacity or cure a supply shock.